The P/B-ROE Model Revisited

Abstract

A two-stage stock valuation model derived from Wilcox's (1984) P/B-ROE approach is shown to be a surprisingly effective tool for a broad variety of uses, including the explanation of current prices and the prediction of future return differences. This applies both to the cross-section of individual US stocks and the time-series of the S&P 500 index. In addition to offering a new closed-form expression for firm value, the model measures the investment horizon over which the market predicts exceptional profitability, demonstrates the dependence of expectations for future profitability on past volatility of return on equity, and quantifies the extent of the recent US stock price bubble. Perhaps its most persuasive result is its no-look-ahead statistical support for tactical asset allocation.

Keywords: P/B, ROE, Valuation, market efficiency, TAA, Tactical Asset Allocation, explanation, prediction

JEL Classification: G12, G14, G30, G31